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COST & MANAGEMENT ACCOUNTING

UNIT NO.IV

Ratio Analysis:

MBA

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SYLLABUS

1.1Introduction, Meaning of Ratio

1.2 Mode of Expression; Steps in Ratio Analysis

1.3 Importance of Ratio Analysis

1.4 Nature of Ratio Analysis

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SYLLABUS

1.5 Limitations of Ratio Analysis

1.6 Classification of Ratios

1.7 Balance Sheet Ratios; Revenue Statement Ratios; Activity of Turnover Ratios;

1.8 Profit Cover Ratios; Du pont Chart 1.9 Miscellaneous Practical Problems.•

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LEARNING OBJECTIVES

1.1Introduction, Meaning of Ratio

1.2 Mode of Expression; Steps in Ratio Analysis

1.3 Importance of Ratio Analysis

1.4 Nature of Ratio Analysis

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LEARNING OBJECTIVES

1.5 Limitations of Ratio Analysis

1.6 Classification of Ratios

1.7 Balance Sheet Ratios; Revenue Statement Ratios; Activity of Turnover Ratios;

1.8 Profit Cover Ratios; Du pont Chart 1.9 Miscellaneous Practical Problems.•

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Classification of Ratios• Classification of Ratios

Balance Sheet Ratios Revenue /Income Statement Ratios

Activity/Turnover ratio & mixed ratios

Current Ratio Profitability Ratios Capital Turnover RatioLiquid Ratio (Acid Test Ratio) Gross Profit Ratio Fixed Assets Turnover RatioAbsolute Liquidity Ratio Net Profit Ratio Current Assets Turnover RatioAbsolute Cash Ratio Operating Profit Ratio Net working capital Turnover

RatioDebt to Equity Ratio Operating Ratio Stock Turn over RatioProprietary Ratio Expense Ratio Debtors Turnover RatioCapital Gearing Ratio Interest Coverage

RatioCreditors Turnover Ratio

Pref Dividend Coverage Ratio Cash Profit RatioDebt Service Coverage Ratio

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Classification of Ratios

• Some other ratiosIn Relation to Investment In Relation to Equity Shareholder’s Fund

Return on Total Asset Return on Equity Shareholder’s Funds

Return on Capital Employed Earning Per share

Return on Shareholder’s Funds Dividend Per share

Return on Equity Shareholder’s Funds Price-Earning Ratio

Dividend Payout Ratio

Earning Yield

Dividend Yield

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Liquidity Ratio:

• Current Ratio

• Quick Ratio

• Absolute Cash Ratio

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Current Ratio

• Meaning : The ratio establish relationship between current assets and current liabilities

• Formula

• Current Ratio = Current Assets• Current Liabilities

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• Objective: 1.To measure the ability of the firm to meet is

short-term obligation

2. To reflect the short-term financial strength/solvency of a firm

3. To measures the safety margin available for creditors.

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Components of Current RatioCurrent Assets ( converted into cash in a year)

Current Liabilities ( To be paid within an accounting year)

Cash Balance Creditors for goods

Bank Balance Bills payable

Debtors ( after deducting provisions) Creditors for expenses

Bills Receivable Bank Overdraft

Marketable Securities Provision for Tax

Stock of Raw -Materials Short-term Loans & Advances

Stock of Work-in-Progress Unclaimed dividend

Stock of Finished Goods Incomes received-in-advance

Prepaid Expenses

Short-term Loans & Advances

Outstanding income

Income accrued but not due

Advance payment of tax & TDS

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Q1. Current Assets Rs. 2,00,000, Stock Rs. 1,00,000, Working capital Rs. 1,20,000. Calculate Current Ratio.

Q2. Creditors Rs. 20,000. Working Capital Rs. 3,60,000, Other current Liabilities Rs. 1,00,000.

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• The Balance Sheet of T Ltd. as at 31st March 2013 are as under:Liabiities Amt (Rs) Assets Amt (Rs)

Equity Share Capital 1,00,000 Land & Building 6,00,000

18% Pref. Share Capital 1,00,000 Plant & Machinery 5,00,000

General Reserve 60,000 Furniture & Fixture 1,00,000

Profit & Losss A/c 2,40,000 12,00,000

15% Debentures 8,00,000 (-) Depreciation (200,000)

Trade Creditors 40,000 10,00,000

Bills Payable 30,000 Trade Investment (LT) 1,00,000

Outstanding Expenses 20,000 Stock 95,000

Bank Overdraft 10,000 Debtors 3,40,000

Provision for Tax 2,40,000 (-) Provisions 30,000 3,10,000

Marketable Securities 10,000

Cash 10,000

Bills Receivables 10,000

Prepaid Expenses 5,000

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Preliminary Expenses 60,000Underwriting Commission 40,000

16,40,000 16,40,000

Net Sales for the year 2011-2012 amounted to Rs. 20,00,000. Net Profit after tax 2,40,000, tax @ 50%. Calculate Current Ratio as at 31.3.2012.

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Liquid Ratio/Quick Ratio• Meaning: This ratio establishes a relationship

between Quick Assets & Current Liabilities or Quick Assets & Quick Liabilities

• Objective: • To measure the ability of the firm to meet its

short-term obligations as and when due without relying upon the realization of stock

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COMPONENTS

• 1. Quick Assets: Refer to those assets which can be converted into cash immediately or at a short notice. ( Current Assets –Stock –Prepaid Expenses)

• 2. Quick Liabilities = ( Current Liabilities- Bank OD –Cash Credit)

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• F• Formula:

• Quick Ratio = Quick Assets/Current Liabilities

• or

• Quick Ratio = Quick Assets/Quick Liabilities

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• Calculate Quick Ratio

• 1. Current Assets Rs. 4,40,000, Stock Rs. 95,000, Prepaid expenses Rs. 5,000, Current Liabilities Rs. 3,40,000

• 2. Current Assets Rs. 2,00,000, Inventory Rs. 40,000, Working Capital Rs. 1,20,000.

• 3. Current Liabilities Rs. 1,20,000. Working Capital Rs. 3,60,000, Creditors Rs. 20,000, Inventory Rs. 1,20,000, Calculate Quick Ratio.

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Absolute Cash Ratio

• Meaning:• This ratio measures a relationship between

cash & marketable securities & Current Liabilities.

• Formula• Absolute Cash Ratio• = Cash & Marketable Securities/ C L

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• From the following Calculate, Absolute Cash Ratio;

Inventory Rs. 4,00,000 Marketable Securities Rs. 1,00,000

Debtors Rs. 3,50,000 Current Liabilities Rs. 5,00,000

Cash Rs. 2,00,000 Provision for Doubtful Debts

Rs. 50,000

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Debt to Equity Ratio

• Meaning:• The Ratio establishes the relationship

between long term debt and share holders fund.

• Objective:• To measure the relative proportion of debt

and equity in financing the assets of a firm.

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• Components:

• 1. Long-term Debts: Which means long term loans ( whether secured or un secured) ( e.g. debentures, bonds, loans from financial institutions).

• 2. Share holders’ fund: Which means Equity share capital + Preference share capital Plus reserves and surplus (-) fictitious assets (e.g. preliminary expenses)

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• Computation: This ratio is computed by the following formula:

• Debt to equity ratio= Long Term Debt Shareholders’ Fund

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Proprietory Ratio

• Meaning:• This ratio measures the relationship between

equity or Shareholders’ fund and total assets.

• Objective:• To measure the proportion of total assets

financed by Equity or Shareholders’ Fund or Proprietors’ Fund.

Computation: It is computed by the following formula:

Proprietory Ratio = Proprietors’ Fund/Total Assets*100

The ratio indicates the extent to which the assets of the enterprise have been financed out of proprietors’ funds.

Traditionally, a proprietory ratio of 1:4 is considered satisfactory , which means 25% of the total assets are financed out of equity.

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Computation of Shareholders’ Fund or Equity

Liabilities Side Approach AMT Asset Side Approach AMT

Equity share Capital Net Fixed Asset

(+) Resrves & Surplus (+) Trade investment

(Less) Misc Exp (+) Current Assets

Equity Sharholder’s Fund Total Assets

(Add) Pref Share Capt (-) Current Liabilities

Shareholders’ Fund or Proprietors’ Fund

Capital Employed

(-) Long term Debt

Shareholders’ Fund /Proprietors’ Fund

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Capital Gearing Ratio

• Meaning:• This ratio establishes a relationship between

funds bearing fixed financial payment and Equity Shareholders’ Fund

• Objective: • To measure the relative proportion of funds

bearing Fixed financial payments to Equity Shareholders’ Fund.

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• Components:• 1. Funds bearing fixed financial payment:• Debentures, bonds, loans from financial

institutions, preference share capital.

• 2. Equity Shareholders’ Fund: Equity share capital + Reserves & Surplus (-) Fictitious assets.

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• Debt to Equity Ratio:• Taking the same example of Q3. In Current Ratio

Calculate Debt to Equity Ratio.• • Proprietory Ratio:• • Net Fixed Assets Rs. 10,00,000, Long Term Trade

Investments Rs. 1,00,000, Current Assets Rs. 4,40,000, Preliminary Expenses Rs. 60,000, Underwriting Commission Rs. 40,000, Equity Share Capital ( Rs. 10 Each) Rs. 1,00,000, 18% Pref. Share Capital Rs. 1,00,000, Reserves Rs. 1,00,000, P & L A/c ( Opening Balance) Rs. 2,00,000, 15% Debentures Rs. 8,00,000, Current Liabilities Rs. 3,40,000.

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• Capital Gearing Ratio:• Calculate the Capital Gearing Ratio from the

following:• 15% Long-Term Debt Rs. 8,00,000, 18%

Preference Share Capital Rs. 1,00,000, Equity Share Capital Rs. 2,00,000. Reserves & Surplus Rs. 1,50,000, Preliminary Expenses Rs. 50,000.

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Preference Dividend Coverage Ratio• Meaning: • This ratio establishes a relationship between Net

profits after interest and taxes and Preference dividend on preference share.

• Objective:• To measure the Preference shares servicing

capacity of a firm so far as Fixed Dividend on Preference Share is concerned.

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• Components:• 1. Net profits after interest and taxes;• 2. Preference Dividend on Preference Shares.

• Computation: By the following formula:

• Preference Dividend Coverage Ratio• = Net profits after interest and taxes• Pref Dividend on Pref. Shares

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• Interpretation:

• This ratio shows the number of times the amount of Preference Dividend is covered by

the profits out of which Pref. Dividend will be paid.

It indicates the limit beyond which the ability of the firm to service its preference shares capital would be adversely affected.

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Debt service Coverage Ratio:

• Meaning: This ratio measures the relationship between

Net profit before Interest &Tax and interest + Principal portion of installment.

• Objective: To determine the firm’s capacity to pay off

both the interest and principal portion of installment.

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• Components:• 1. Net Profit before interest & Tax• 2. Interest and principal portion of installment

• Debt-service Ratio• = Net Profit before Interest & Tax = times. Interest + Principal portion of installment 1-Tax Rate

It indicates the limit beyond which the ability of the firm to service its debt would be adversely affected.

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Interest Coverage Ratio

• Meaning:• The ratio establishes a relationship between Net

profits before interest and taxes on long-term debt.

• Objective:• To measure the debt servicing capacity of the

firm so far as fixed interest on long-term debt is concerned.

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• Components:• 1. Net Profit before interest & Tax • 2. Interest on long term debt

• Computation: By the following formula Interest coverage Ratio = Net Profit before interest & Tax Interest on long term debt

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Capital Turn-Over Ratio• Meaning:• The ratio establishes a relationship between

net sales and capital employed.

• Objective: To determine the efficiency with which the

capital employed is utilized.

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• Components:

• 1. Net sales (Gross sales – sales return)• 2. Capital Employed.

• Computation: By the following formula

Capital Turn over ratio = Net sales/Capital Employed

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Calculation of capital employed

Liabilities Side Approach Rs. Assets Side Approach Rs.

Equity Share Capital xxxxxxx Net Fixed Assets xxxxxxx

(+) Reserves & Surplus xxxxxxx (+) Trade Investment xxxxxxx

(-) Miscellaneous Expenditure xxxxxxx (+) Current Assets xxxxxxx

Equity Share holders’ Fund xxxxxxx Total Assets xxxxxxx

(+) Preference Share Capital xxxxxxx (-) Current Liabilities xxxxxxx

Shareholders’ Fund xxxxxxx Capital Employed xxxxxxx

(+) Long –term Debts xxxxxxx ( Non –Trading Assets should not be included while calculating Total Assets)

xxxxxxx

(-) NonTrading Assets xxxxxxx ( Advance purchase of fixed assets, xxxxxxx

Capital Employed xxxxxxx Capital W.I.P. , Non Trade Investment s)

xxxxxxx

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• Preference Dividend Coverage Ratio:

• 1. Calculate Preference Dividend Coverage Ratio from the following information:

• 15% Debentures Rs. 8,00,000, Net Profit before Interest & Tax Rs. 6,00,000, Tax 50%, 16% Rs. 100,000 Pref Shares of Rs. 100 each.

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Debt-Service Coverage Ratio: • 2. Net Profit before interest & Tax Rs. 8,50,000, 10% Debentures

( payable in 10 installments) Rs. 7,00,000. Tax Rate 30%, Calculate Debt-Service coverage Ratio.

•

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Fixed Asset & current Asset Turnover Ratio

Meaning: Establishes relationship between Net Sales &

Fixed Assets. Objective: To determine the efficiency with which the fixed

assets are utilizedComponents: 1. Net Sales: which means gross sales – sales

return 2. Net Fixed Operating assets - Depreciation

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• Computation: By the following formula

• Fixed Assets Turnover Ratio = Net Sales / Net Fixed Operating Assets. Current Assets Turnover Ratio = Net Sales / Current Assets.

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Working Capital Turnover Ratio

• Meaning: This ratio establishes a relationship between

net sales and working capital.

Objective:To determine the efficiency with which working

capital is utilised.

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• Components: 1. Net Sales: Which means Gross sales (–)Sales return 2. Working Capital: Current Assets (-) Current Liabilities Computation: By the following formula

Working Capital Turnover Ratio = Net Sales/ Working Capital

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Stock Turnover Ratio

• Meaning: This ratio establishes relationship between cost of

goods sold and average inventory of finished goods.

Objective: To determine the efficiency with which inventory is

converted into sales.

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• Components: 1. Cost of goods sold = Opening Inventory + Net

Purchases + Direct Expenses (-) Closing inventory or Net Sales – Gross Profit. 2. Average Inventory: Opening Inventory + Closing inventory /2 Computation: By the following formula Stock Turnover Ratio = Net Sales/Average Stock Or :

= COGS / Average stock at cost

• Stock Velocity: The velocity indicates the period for which sales can be generated with the help of an average stock maintained and is expressed in terms of period.

• Computation: By the following formula• Stock Velocity = Average Stock /Average cost of goods sold per day = ……DaysOr 12months/52 weeks/365 days = Months/Weeks/Days

Stock Turnover Ratio

Average Cost of Goods sold per day= Cost of Goods Sold/ No of working days in the year.

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Debtors Turnover Ratio

• Meaning: It establishes a relationship between credit sales and average trade debtors.

• Objective: To determine the efficiency with which trade

debtors are converted into cash.

• Components:• 1. Net Credit Sales: Gross Credit Sales (-) Returns• 2. Average Debtors (or Receivables):= Opening Debtors + Opening B/R (+) Cl Debtors + Cl B/R 2 Computation: By the following formula Debtors Turnover Ratio= Net Credit Sales/Average Debtors

It indicates the speed with which debtors are converted into cash. It also indicates both the quality of debtors and the credit collection efforts of the enterprise.

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Average Collection Period/Debtors’ Velocity

• Meaning: This period shows the average period for which

the credit sales remain outstanding or the average credit period actually enjoyed by the debtors.

It indicates the rapidity or slowness with which the money is collected from debtors.

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• Calculated by the following formula:

Debt Collection Period = Average Debtors /Average Net Cr sales per day or = 12 months/52 weeks/365 days = Months /weeks/days Debtors Turnover Ratio

Note: Avg Credit sales per day = Net credit sales for the year/ No. of working days in the

year

Creditors Turnover Ratio or Payable Turnover Ratio

• Meaning: The ratio establishes a relationship between net

credit purchases and average creditors or payables.

Objective: To determine the efficiency with which creditors

are managed and paid.

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• Components: 1. Net Credit Purchase: Gross credit purchase (- )Returns 2. Average Creditors(or Payables) Opening Creditors + Opening B/P + Cl Creditors + Cl B/P 2Computation: By the following formula Creditors Turnover Ratio = Net Credit Purchase/Average Creditors

It indicates the speed with which the creditors turn over on an average each year. In general a high ratio indicates the shorter payment period and a low ratio indicates high payment period.

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Debt Payment Period (or Creditors’ Velocity)

• This shows an average period for which the credit purchases remain outstanding or the average credit period actually availed of.

• Calculated by the following formula:• Avg Debt Payment Period = Avg Creditors/ Avg Net Credit

purchase per day = …daysOr = 12 months/52 weeks/365 days = Months /weeks/days Creditors Turnover Ratio Note: Avg Credit Purchases per day = Net credit Purchases for the year/ No. of working days in

the year•

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Return on Total Asset• Meaning: It measures the relationship between Net

profit before interest and tax, and total assets

• Objective :

To find out how efficiently the total assets have been used by the management.

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• Components:

1. Net profit before interest & tax

2. Total Assets: ( excluding fictitious assets e.g. preliminary expenses)

Components: By the following formula

Return on Total Assets

= Net profit before interest & Tax * 100 = ……%

Total Assets

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Return on Capital Employed/Return on Investment (ROI)

• Meaning: This ratio measures a relationship between net

profit before interest and tax and capital employed.

Objective: To find out how efficiently the long-term funds

supplied by the creditors and shareholders have been used.

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• Computation: By the following formula

Return on capital employed

= Net profit before interest & Tax* 100 = …..%

Capital Employed

This ratio indicates the firm’s ability of generating profit per rupee of capital employed.

Higher the ratio more efficient the management and utilization of capital employed

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Return on Shareholders’ Fund or Return on Equity

• Meaning: It measures the relationship between net profit after Interest & Tax, and shareholders’ funds.

• Objective: To find out how efficiently the funds supplied by

al the shareholders ( Equity and preference) have been used.

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• Components: • 1. Net Profit after Interest & Tax• 2. Shareholders’ funds

• Computation: By the following formula

• Return on Shareholders’ Fund

= Net Profit after Interest & Tax * 100 = …..%

Shareholders’ funds

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Return on Equity Shareholders’ Funds

• Meaning: This ratio measures the relationship between Net Profit After Interest & Tax – Preference Dividend & Equity Shareholders’ Fund.

• Objective: To find out how efficiently the funds supplied by

the equity shareholders have been used.

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• Components:• 1. Net Profit after interest & tax –Pref Dividend• 2. Equity Shareholders’ Funds: Equity share

capital + Reserves & Surplus (-) Fictitious Assets.

• Computation: By the following formula Return on Equity Shareholders’ Funds = Net Profit after interest & tax –Pref Dividend*100 Equity shareholders’ Fund

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Earning Per Share(EPS)

• Meaning: It measures the earnings available to the equity shareholder on a per share basis.

Objective:

To measure the profitability of the firm on per equity share basis.

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• Components:

1. Net profit after interest & Tax (-) Pref Div

2. No. of Equity Share Outstanding.

Computation: BY the following formula

EPS = Net profit after interest & Tax (-) Pref Div

No. of Equity Share Outstanding.

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Price Earning Ratio (PER)

• Meaning: It measures the relationship between the market price per share and earning per share.

• Objective:• To Find out the expectations of the shareholders

about the earnings of the firm.

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• Components:• 1. Market Price Per share• 2. Earning Per share

• Computation: BY the following formula

Price Earning Ratio = Market Price Per share

Earning Per share

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• Interpretation:

• It indicates the no of times of EPS, the share is being quoted in the market.

• In other words, it indicates the payback period within which the prospective investor can recover his investment in a single share by way of Earning Per Share.

Earning Yield Ratio (EY)

• Meaning: The ratio measures the relationship between Earning Per Share (EPS) & Market Price Per Share.

• Objective:

To measure the performance of earnings in relation to market price per share.

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• Components:

1. Earning Per Share

2. Market Price Per Share

Computation: By the following formula

Earning Yield = Earning Per Share (EPS)* 100

Market Price Per Share

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Dividend Per Share• Meaning: It measures the dividend distributed per

equity share.

• Objective:

The objective is to measure the dividend distributed per equity share.

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• Components: • 1. Profit distributed as Equity dividend• 2. Number of Equity Shares

• Computation: By the following formula

• Dividend Per Share (DPS)

= Profit distributed as Equity dividend = Rs. ……

Number of Equity Shares

Dividend Payout Ratio:

• Meaning: It measures the proportion of earning per share distributed as dividend.

• Objective: • TO measure the portion of EPS distributed as

dividend.

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• Components:• 1. Earning Per Share (EPS)• 2. Dividend Per Share (DPS)

Computation: By the following formula

Dividend Payout Ratio

= Dividend Per Share (DPS) *100

Earning Per Share (EPS)

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Dividend Yield Ratio

• Meaning:

It measures the relationship between Dividend Per Share (DPS) & Market Price Per Share.

Objective:

To measure the performance of dividend in relation to market price per share.

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• Components:• 1. Dividend Per Share (DPS)• 2. Market Price Per Share

• Computation: By the following formula

• Dividend Yield = Dividend Per Share (DPS)* 100

Market Price Per Share

• Return on Total Assets• Net profit after interest & tax Rs. 2,40,000, Tax rate 50%,

Net Fixed Assets Rs. 10,00,000, Long Term Trade Investments Rs. 1,00,000, Current Assets Rs. 4,40,000, Preliminary Expenses Rs. 60,000, Underwriting Commission Rs. 40,000, Equity Share Capital ( Rs. 10 Each) Rs. 1,00,000, 18% Pref. Share Capital Rs. 1,00,000, Reserves Rs. 1,00,000, P & L A/c ( Opening Balance) Rs. 2,00,000, 15% Debentures Rs. 8,00,000, Current Liabilities Rs. 3,40,000.

• Return on Capital Employed/Return on Investment (ROI):• Taking the same illustration of Return on Total Assets

Calculate the Return of Capital Employed.77

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• Return on Shareholders’ Fund or Return on Equity (ROI)

• Taking the same illustration of Return on Total Assets Calculate the Return of Shareholders’ Fund or Return on Equity.

•  • Return on Equity Shareholders’ Fund• Taking the same illustration of Return on Total

Assets Calculate the Return of Equity Shareholders’ Fund.

•